A mortgage is a loan secured by the collateral of some specified real estate and is a contractual agreement between the lender and the borrower that pledges the property to a lender as security for the repayment of the loan through a series of payments. The mortgage also entitles the lender (the mortgagee) the right of foreclosure on the loan if the borrower (the mortgagor) fails to make the contracted payments.
Mortgages can be divided into categories on the basis of various attributes: whether the real estate is residential, like single family houses or multiple family condominiums, or commercial, like office buildings, shopping malls, hotels, warehouses, factories; whether the loan is “conventional” or “guaranteed”—that is guaranteed by a government agency as is the case with borrowers eligible for special loan programs established by the Federal Housing Administration (FHA), the Veteran's Administration (VA), or the Rural Development Administration (RDA); whether the rate of interest on the loan is fixed in advanced (fixed rate mortgage), adjusts (ARM or adjustable rate mortgage) with a market index such as a six-month index based on the London Interbank Offer Rate (LIBOR) or 1 year Constant Maturity Treasury Indexes (CMT), or is a hybrid that is fixed for a period of time such as 1, 3, 5, or 7 years and is then becomes adjustable; and how and when the amortization, or the payment of the principal of the loan, is to occur (for example, a loan may have a fixed amortization period such as 10, 20, 30, 40 years (or as is common in Asia, 100 years), may be an interest-only loan with the principal due at the end of the loan, or may be interest only for a period of years and then change to a 30 year amortization period).
The market where the funds are borrowed is called the mortgage market. Typically, in this market there is a primary market consisting of individual borrowers, original lenders (who are typically banks or other financial institutions), and brokers. There is also a secondary market in which original lenders sell packages of loans to investors. These investors can be other banks, corporations, wealthy individuals, and the three Government Sponsored Enterprises (GSEs) (i.e., the Federal Home Loan Mortgage Corporation (Freddie Mac), the Government National Mortgage Association (Ginnie Mae), and the Federal National Mortgage Association (Fannie Mae)).
The simplest such packaging in the secondary market is a Mortgage Backed Security (MBS) that allocates payments of principal and interest from a pool of mortgages to an investor. As the package is a tradable security, the investor can decide at any time to sell the MBS to another investor on an actively traded market for such purposes. More advanced packaging can take various forms and structures such as Collateralized Mortgage Obligations (CMOs) that can separate out the principal and interest payments and also be used to manage risk by meeting specific maturity and volatility requirements of investors.
The primary risks that are being managed by investors in mortgage pools are the risks of default and prepayment. Default occurs when the borrower is unable or refuses to pay the loan. Many borrowers will default because of financial problems leading to bankruptcy. Another source of default is related to legal issues and explains default by some high-net-worth borrowers who are not in danger of bankruptcy. For example, because some states, such as California, limit a lender's security on an original (or “purchase money”) mortgage to the real estate, some borrowers will default when real estate prices have fallen below the original purchase price. In the short run, it can be financially more advantageous to default than to pay the loan on a home with negative equity. Default risk is typically managed at the individual mortgage level through private mortgage insurance and, in some cases, pool-level guarantees of the three GSEs or by Government Agencies such as the Veteran's Administration. Prepayment is the opposite risk—the risk of a loan being paid-up ahead of schedule. Prepayment of existing loans typically occurs for two primary reasons: the turnover of the real estate to a new owner, and refinancing activity. Refinancing can be advantageous for borrowers when there is a reduction in available market interest rates not reflected in the borrower's existing loan or during the introduction of market innovations such as interest-only loans that can reduce the monthly payment of the borrower. The risks of prepayment subtract value from MBSs.
The borrower's abilities to default or prepay can be seen as two risk-management tools for the borrower. However, both default and prepayment are costly to lenders and investors and, with default, also to the borrower in terms of bad credit history. Innovations have stepped in to provide alternatives with benefits to both parties.
Currently, adjustable rate mortgages offer the borrower a lower rate now than fixed rate mortgages and exposure to the possibility of lower rates in the future (reducing prepayment risk to the lender/investor) in exchange for the borrower accepting the risk of higher rates in the future.
Some interest-only and teaser-rate loans offer a borrower an initial escape from high payments, but are often structured with a very low—below market—initial rate (e.g., 1%, 3%, etc.) and then a higher adjustable rate later on (e.g., 6 mo LIBOR+4%). For example, recently the 6 month LIBOR index rate was about 4.75% so that a LIBOR+4% loan would have an interest rate of about 8.75%. Borrowers who have agreed to these terms can expect their payments to multiply by a factor of 300% to 800% when the loan switches from the 1-3% fixed rate to the ˜8.75% variable rate even if future rates do not increase further. If future rates rise, the effect will be even more profound.
By lowering interest rates and/or payments, these loans have enabled borrowers to make a $1 trillion bet on low future interest rates, rising future real estate prices, and rising future incomes. These bets come due when hybrid fixed/adjustable loans switch from the initial fixed-rate (which may be below market) to a market based adjustable rate. In 2005, an estimated $80 billion of mortgage debt was set to switch to an adjustable rate. The estimates for 2006 and 2007 are $300 billion, and $1 trillion, respectively. It seems likely that these bets may need to be hedged, both by the borrowers and by the lenders. This will most likely occur through refinancing to new products that are better able to account for and explain these risks.
The teaser-rate loans are an example of a market response to the borrower's need for low payments to qualify on a loan and lender's desire for high yields in selling the loans to investors. The market is very payment and interest rate sensitive. Initial buyers want to either minimize their payments or maximize their house purchasing power, while borrowers going through refinancing may be carefully rate shopping for their best subjective combination of fixed and adjustable rates.
Opportunities for a suite of new financial products in the primary and secondary lending markets exist for presenting new rates and risk profiles to the borrower and for greater transparency in how interest rate risk is to be shared between lenders and borrowers. Some of these opportunities can include third parties such as investors, insurers, or securities market participants. Many of these opportunities involve chopping-up well known financial derivatives products, such as swaps or options on $100 million of financing, into pieces suitable for residential borrowers. Other opportunities exist from enabling residential borrowers to hedge as only rich corporations and financial experts are able to do today.